Published October 8, 2011
One of the great comforts to average investors is dollar-cost averaging, but new research raises questions about that investing philosophy. By Paul Sullivan
SINCE mid-August, world markets have repeatedly moved with stomach-churning ups and downs. And in response, many investors feel they must take some action for fear that doing nothing will cost more than doing something.
The sheer magnitude of the world's problems - high unemployment and legislative gridlock in the United States, debt problems in Europe, signs of a slowdown in China - makes this a scary time for investors.
But what about the urge to take some sort of action? The better strategy is almost always to focus on a long-term plan and not abandon it the moment it gets tested. After the past three years, this is tougher to do than ever.
'It's very hard to do nothing when everybody is trying to talk you into doing something, even when it's wrong,' said Susan Fulton, founder and president of FBB Capital Partners.
Wild swings
Michael Martin, a trader and the author of the new book The Inner Voice of Trading (FT Press), put it a different way. The big risk for average investors now is confusing volatility with opportunity.
He said professional traders become more wary when prices are changing rapidly for no fundamental reason. And he equated the market, with its wild swings, to a drunken uncle at a holiday dinner.
'When someone's behaviour becomes more volatile, you don't want to warm up to that person,' he said. 'You want to get away.'
But ignoring those swings can be difficult. Below are some bad ideas as well as some slightly contrarian thoughts that may offer comfort:
Fear causes investors to do all sorts of things that could hurt them in the long run.
The recent drop in gold prices to about US$1,600 an ounce from just under US$1,900 in August has damped down some of the enthusiasm for gold. But the gyrations in stocks have led some investors to think they can find something there that will soar as gold did.
'People want to swing for the fences,' Ms Fulton said. 'We're not going to have stocks that multiply by 10 in the near future.'
She said she advised clients to look instead at companies that had a lot of cash and were paying steady dividends. There is a predictability to those stocks that will help battered portfolios.
A variation on the stock-picking strategy involves using tax losses accumulated over the years to bet heavily on a risky company. The hope is that any gains will get an investor back to even and also be tax-free.
The problem is that unless the investor picks the next Google, his losses could be substantial. And even if he's lucky enough to pick a stock that appreciates greatly, it could be years before he sells the stocks and is able to use the tax losses to offset the gains.
'You should use your tax losses on things that can benefit you today,' said Lewis Altfest, chief investment officer of Altfest Personal Wealth Management.
Mr Altfest said a client recently wanted him to put money into some risky stocks because he was down so much. Instead of agreeing, Mr Altfest suggested the client reallocate his portfolio back to 65 per cent stocks and 35 per cent bonds and then go back to that allocation whenever the stock position dropped below 63 per cent.
'He's got a human problem now - he's behind,' Mr Altfest said. 'I could explain to him that this is the worst recession we've had in 80 years. It might help him intellectually, but he hurts, and he wants an answer.'
One of the great comforts to average investors in a volatile market is dollar-cost averaging. This is a fancy way of saying you should invest your money over a period of time as opposed to investing it all at once, which is known as lump-sum investing.
Proponents of dollar-cost averaging offer two arguments. By putting money into, say, a stock over time, you will be buying shares at varying prices, which will benefit you in the end. This seems particularly appealing when stock prices are rising and falling so much.
The second advantage is psychological: If you put all your money into an investment and it is worth 10 per cent less the next day, you're going to feel horrible about it. Worse, you may also be less inclined to make further investments or pull your money out.
But new research from Gerstein Fisher, a money manager in New York, raises questions about that investing philosophy. It found that from January 1926 to December 2010, investing your money on one day yielded better results over a 20-year period than investing the same amount of money in equal chunks over 12 months.
In the 70 per cent of the time that investing everything all at once did better, it did better by 94 percentage points. When dollar-cost averaging did better, it did so only by 77 percentage points. Over a 20-year period, lump-sum investing added about 2 per cent to annual returns, the study found. This ratio continued to hold true over the past decade.
Betting on bonds
'The conclusion is the faster you invest the money, the better you do,' said Gregg Fisher, president and chief investment officer of Gerstein Fisher. 'Dollar-cost averaging's greatest value is to get people comfortable investing. The rational investor would not do it because it doesn't make any sense, but we're not rational.'
Normally, most investors don't have large sums of money to invest at once. But right now, many are sitting on large cash positions.
Mr Fisher did note that the person who put money in slowly was still better off than the person who tried to guess the direction of the market.
Another bit of consolation is that government bonds may be better bets than many advisers have been saying.
But Bob Andres, chief investment officer and strategist at Merion Wealth Partners, said investors had been too optimistic. There are few signs that the global economy is getting any better.
'If you're at 2.5 per cent on a 10-year Treasury or lower, people have a tendency to say they can't go any lower,' Mr Andres said. 'That's a mistake. That's underestimating the problems the global economy has. Do I think we can go back down to 1.5? Yes, I do.'
However depressing his analysis, it has some merit. At the beginning of the year, the yield on the 10-year Treasury was 3.36 per cent, which did not seem like such a great return then. But last week, when the yield on the same bond hit a low of 1.72 per cent, it looked a lot better.
So while inflation would still be bad for bond returns, there is enough bleak news coming from the US and Europe to make a rush out of Treasury bonds premature.
'Not losing money is much more important than making money in this environment,' Mr Andres said. 'Intuitive feel is a dangerous thing in a market like this.'
Under pressure, the best advice may be to stay the course. -- NYT
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